Revenue Volatility
In California

Following the boom-bust revenue cycle in recent years, concerns have developed
about volatility in California's General Fund
revenues. This brief quantifies the amount of
revenue volatility experienced in California during the
past quarter century, identifies the main causes of
the volatility, and discusses the outlook for volatility in the future. We also highlight
some options for reducing future impacts of
volatilityboth those involving changes to the tax system
and budgetary changesand discuss the trade-offs inherent in each of the alternatives.

Introduction

California's system of taxes that supports the General Fund has been in place for many
years. Its main elementsthe personal income
tax (PIT), sales and use tax (SUT), and
corporation tax (CT)were established over half a
century ago. The system has performed relatively
well through most of the intervening period and
has generally received good marks from economists and public finance experts. For example,
it is diversified and relatively broad-based,
thereby ensuring that all types of individuals,
businesses, income, and economic activity contribute to
the financing of public services. It also provides revenues that increase over time in response
to growth in the state's population and economy, thus helping ensure that the state can fund
the public services that demographic growth requires, such as education and infrastructure.

Despite its generally positive features, there are certain areas where California's tax
system could benefit from reforms, such as those making it more reflective of the state's
modern economy and more neutral with respect to
its effects on economic decision-making. One particular concern which has emerged in
recent years is the current system's relatively
high degree of volatility. As shown in Figure 1, annual fluctuations in General
Fund taxes have been quite significant. These
fluctuations have been considerably more
pronounced than the volatility in California's
overall economy, and more substantial than the revenue fluctuations experienced in other
states. This revenue volatility has contributed to
major problems for state policymakers attempting
to manage and balance California's state government budget. This has been particularly
true during the past five years, when General Fund revenues increased by as much as 20 percent
in 1999-00 but then plunged by a dramatic
17 percent in 2001-02.

Given its significance, this report focuses on the revenue volatility issue. In it we define
and quantify the amount of revenue volatility
California has actually experienced, identify and
discuss the main factors contributing to this
volatility, and examine the key policy options available
to the Legislature for dealing with such volatility
in the future.

What Exactly Is Meant by Revenue Volatility?

As noted above, revenue volatility in broad terms refers to fluctuations over time in
tax receipts. Actually, however, there are a
number of different characteristics and dimensions
that such revenue fluctuations can have, which in turn can determine both the challenges
volatility poses for policymakers and the best options
for dealing with it. These factors include:

Amount and Frequency of
Variability. There can be year-to-year growth fluctuations
that are frequent but of modest size, fluctuations that are infrequent
but of more dramatic magnitude, or any number of other
possible patterns. (There can also be dramatic
revenue fluctuations within fiscal
years, which can have significant implications for
cash-flow and intra-year borrowing needs.)

Varying Underlying Causes. Some
fluctuations are closely related to business cycles
and their impacts on such variables as personal income
and employment. In other cases, however, fluctuations can
be primarily caused by changes in such factors as capital gains and
stock options, which may be only loosely related to the
general business cycle.

Given the above, revenue volatilitythough perhaps simple in conceptis in reality a
multi-dimensional and often complex phenomenon.

How We Measure Volatility

For this analysis, we focus on two key elements of volatilitynamely, the gross
amount of annual revenue fluctuations, and the extent
to which these fluctuations are related to
cyclical ups and downs in the economy.

Specifically, we analyzed the year-to-year changes in California revenues during
the period 1979-80 through 2003-04. This 24-year period encompasses two major business
cycles, which is important because the nature of
volatility can vary for different phases of
business cycles. As a starting point, we adjusted each
of the state's major individual revenue sources to remove the year-to-year effects on
collections of law changes and other policy-related
factors. This allowed us to isolate the underlying
volatility of the revenue system. We then
calculated several statistical measures, discussed in
more detail in the accompanying box (see page 6),
for each of the adjusted revenue series in order
to capture different aspects of revenue
volatility. These included, for each revenue source: (1) their annual average growth rates; (2) the standard deviations around their growth rates; and (3) the short-term elasticities of the
revenue sources with respect to changes in California's economic activity, as measured by statewide
personal income.

California's Historical Experience With Revenue Volatility

Volatility Has Been Present Throughout The Past Quarter Century

Figure 2 shows the results of our analysis for General
Fund revenues. (Given the indirect effects of
local property taxes on the General Fund through their impacts on
Proposition 98 spending, we discuss the volatility
of the property tax separately in the box below.) The
figure shows that the average annual growth rate
in total General Fund revenues over the
24-year period from 1979-80 through 2003-04 was 6.1 percent. However, the
standard deviation (that is, the average variation
around the long-term growth trend) was an even
larger 8 percent. In other words, total revenues
have been quite volatile.

Figure 2

Average Annual Growth and
Standard Deviation of
California General Fund Revenuesa

Full
Period
1979‑80 Through 2003‑04

Subperiods

1979‑80
Through
1990‑91

1991‑92
Through 2003‑04

Total Revenues

Average growth

6.1%

7.1%

5.2%

Standard deviation

8.0

6.4

9.4

Personal Income Tax

Average growth

7.5%

8.8%

6.5%

Standard deviation

11.9

9.8

13.8

Sales and Use Tax

Average growth

5.2%

6.3%

4.3%

Standard deviation

4.5

4.5

4.5

Corporation Tax

Average growth

4.6%

5.6%

3.7%

Standard deviation

11.4

12.9

10.4

aIn analyzing revenue volatility over time and among different
income sources, it can be helpful to look at a relative measure
of variation in addition to the absolute measure of variation
captured by the standard deviation. A popular relative measure is the
coefficient of variation, defined as the standard deviation divided by
the average growth rate. This measure also shows that volatility has
increased over time, and is greater for both the PIT and CT than for the
SUT.

Statistical Measures for Examining Revenue Volatility

Using data from 1979-80 through 2003-04, our statistical calculations provide
(1) average revenue growth rates, (2) the variability around these average changes, and (3) the extent
to which such variability is related to fluctuations in the state's economy versus other factors.
The specific statistical measures that we used are:

Average Growth Rate and Standard
Deviation. To arrive at a gross measure of revenue volatility, we first calculated the long-term average annual growth
rate by revenue source and what statisticians call the standard deviation (or
average difference) of these annual rates around their long-term average trend rate. As
an illustration, consider a tax that grows at an average annual rate of 6 percent
for which the calculated standard deviation is 4 percent. One can conclude from
this that the annual growth rates will fall between 2 percent and 10 percent
roughly two-thirds of the time. Likewise, in one-third of the time the rates will lie
outside this rangethat is, be less than 2 percent or more than 10 percent. Thus,
the greater the standard deviation, the more volatile is revenue performance.

Short-Term Elasticity With Respect to Personal Income.
This measure shows therelationship between fluctuations in the economy and fluctuations in revenues.
Itaddresses the question: How much of the gross fluctuations in revenues is
due simply to ups and downs in the economy versus other
factors? As an example, consider the case where both revenues and personal income have an average
long-term growth rate of 6 percent. Also, assume that during the expansion phase of
a business cycle, personal income grows 8 percent (2 percent above its
long-term growth rate) but that revenues grow by 10 percent (4 percent above the
long-term trend). Conversely, during the downside of a business cycle, personal
income grows by only 4 percent (2 percent below its long-term trend) but revenues
grow by and even-smaller 2 percent (4 percent below the long-term trend). In this
case, revenues have a short-term elasticity of 2, meaning that fluctuations around their
long-term growth trend will be roughly twice the magnitude of personal income
fluctuations around its long-term growth trend.

Distinction Between Short- and Long-Term
Elasticity. Short- and long-term elasticities
are distinct concepts that measure different attributes of a revenue system. For the historical
period 1979-80 through 2003-04, the long-term elasticity of revenues to personal income was
about 1. This tells us that the cumulative growth in revenues was about the same as the
cumulative growth in personal income over the full period examined. This information is important
for long-term planning purposes. However, the long-term elasticity does not provide
information about the paths taken by revenues and the economy during the intervening individual years.

This information is provided by the short-term elasticity estimates discussed above.
In California, the short-term elasticity of revenues was 2.05 during the 1979-80 through
2003-04 period, meaning that revenues accelerated, on average, by roughly twice as much as
the economy in good times and decelerated by roughly twice as much as the economy
during bad times within the 24-year period examined.

Individual Sources. Regarding
major individual revenue sources, these include:
the PIT, which accounts for about 50 percent
of total revenues; the SUT, which accounts for about 30 percent of the total; and the CT,
that accounts for nearly 10 percent of the total.
Of these major sources, the most volatile have clearly been the PIT and CT, with each
having experienced a standard deviation (that is,
average variation around their long-term growth trend) of over 11 percent for the period as
a whole. In contrast, the SUT has exhibited relatively modest volatility over time, with
a standard deviation of about 4.5 percent.

Volatility Increased Markedly After 1990.
The standard deviation for total revenues increased markedly from 6.4 percent in the
pre-1990 period to 9.4 percent in the
post-1990 period. All of the increase was related to the PIT.
In contrast, the variability of the SUT did not
change much between the two subperiods, and the volatility of the CT actually declined marginally.

Revenues Have Been More Volatile Than the Economy

A key question related to revenue volatility is how much of its annual fluctuations is
related to cyclical changes in the economy (over
which state policymakers generally have
little control in the short term) and how much is due to
the basic underlying characteristics of the tax
structure (which can be changed).

As noted earlier in the top panel of
Figure 1, annual revenues have fluctuated by
considerably more than statewide personal income during the period we examined. Figure 3 shows our estimates of the
sensitivity of annual percent changes in revenues
to those for personal income during economic cycles over the past decade (as noted in
the earlier box, this relationship is referred to
by economists as the short-term elasticity of revenues). It shows that the short-term elasticity
for total revenues was 2.05, implying that, on average, the magnitude of revenue cycles
were about twice the size of economic cycles
during the historical period examined.

Figure 3

Historical Effects of
Economic Cycles on
General Fund Revenues

Effects
of a 1 Percent Change in Personal Income On Percent Changes in
Revenuesa

1979‑80
Through
2003‑04

1979‑80
Through
1990‑91

1991‑92
Through
2003‑04

Personal income tax

2.94%

1.09%

6.24%

Sales and use tax

1.19

1.33

1.44

Corporation tax

1.70

2.57

3.33

Totals, All
Revenues

2.05%

1.39%

3.51%

aBased on short-term elasticity calculations.

The figure also shows that the short-term elasticity jumped sharply during the most
recent economic cyclefrom 1.39 in the
1979-80 through 1990-91 period, to 3.51 in the
1991-92 through 2003-04 period. This implies that revenues became more volatile relative to
the underlying economy during this later period.

The Role of Stock Options and Capital Gains

As we discuss below, there are several factors
behind California's relatively high degree of
revenue volatility. Clearly, the most important factor
in recent years is the extraordinary boom and bust in stock
market-related revenues from stock options and
capital gains. As shown in Figure 4, PIT
revenues from these two sources jumped from about $2 billion in 1995-96 to
a peak of $17 billion in 2000-01, before
plunging to about $5 billion in 2002-03.

As an indication of how important this boom-bust cycle in
stock market-related earnings was to California's volatility picture,
Figure 5 compares actual volatility during the past
24 years to the amount of volatility that would
have existed if stock options and capital gains
had been excluded from the tax base during this period. Specifically,
we estimate that:

The exclusions of stock options and capital gains results in
a roughly one-third reduction in the amount of
revenue volatility during the 1979-80 through
2003-04 period. Specifically the standard
deviation falls from 8 percent to
5.3 percent for this period.

The reduction in volatility is most pronounced in the
1991-92 through 2003-04 period, when the standard deviation falls
from 9.4 percent to 4.9 percent.

Stated another way, the increase in overall revenue volatility
between the pre-1990 and post-1990 subperiods is more than
fully accounted for by the fluctuation in revenues related to stock
options and capital gains.

It should be noted, however, that just as revenues would be considerably less
volatile if stock options and capital gains were not part
of the tax base, average revenue growth itself also would be much less. This is because, even
after the 2001 stock market bust is taken account
of, stock options and capital gains were among the fastest-growing sources of state revenues
and will likely continue to be so over the longer term.

Implications Of Revenue Volatility

Given California's significant revenue volatility experiences over the past two
decades, a natural next question to ask is:
What are the adverse consequences of such
revenue volatility? Understanding this is
particularly important in considering whether and
what steps should be taken to lessen volatility
since, as we discuss further below, reducing
volatility can itself involve trade-offs. These
include reducing the rate at which revenues may
grow and changing how the tax burden itself is distributed.

Large Dollar Variations Occur in Revenues

The first and most obvious impact of revenue volatility involves the large dollar
variations in state revenues that it can produce. To
provide an indication of what the above-discussed percentage estimates of volatility imply in
dollar terms, consider that 2004-05 General Fund revenues (excluding transfers and loans)
are currently expected to be roughly $78 billion.
If revenues were to grow from that level in 2005-06 at the long-term underlying average growth rate of 6.1 percent shown in
Figure 2, the resulting revenue total would be
roughly $83 billion. However, an 8 percent
standard deviation implies that the actual level of
revenues could differ from that amount by an average plus-or-minus margin of
$6 billion, resulting in a revenue range from $77 billion
to $89 billion.

These are extremely large dollar margins. Admittedly, they are probably
somewhat skewed by the extraordinary large volatility
of the late 1990s and early 2000s. However, even after excluding the "outliers" (that is, the years
in which the most extreme fluctuations occurred), the year-to-year variation in past revenue
growth has been considerable and suggests that multibillion-dollar single-year future
revenue swings are more likely than not.

Less Stable and Predictable Program Funding Results

Even if revenue volatility could be accurately predicted, year-to-year revenue fluctuations
of this magnitude make it difficult to provide
stable funding for state programs, and thus
complicate budgeting. Compounding this, of course, is
the fact that to date it has not proved possible
to accurately predict volatility itself. The
forecasting procedures used by both the Department
of Finance and our office do attempt to forecast year-to-year revenue fluctuations by taking
into account the impacts of general economic
cycles and specific economic factors such as
consumer and business spending, housing starts,
employment, profits, and changes in income
distributions. These methodologies have been
successful in predicting a significant portion of
the revenue fluctuations that have occurred in most years.
However, since revenue volatility is related at least in
part to particularly hard-to-predict factors such
as changing stock market values and business profits, it is often associated with increased
forecasting discrepancies.

For example, Figure 6 shows that, using
the estimated short-term elasticities calculated
for the full 1979-80 through 2003-04 historical period found above in Figure 3, a
moderate 2 percent overestimate of economic growth
as measured by personal income would produce a 4.1 percent shortfall in revenues. This
would translate into a dollar shortfall of over
$3 billion in 2005-06 terms. Alternatively, using the
greater elasticities generated for the post-1990
period, the dollar shortfall would exceed $5 billion.

Figure 6

Revenue Shortfall From a 2
Percent Over-Estimate of
California
Personal Income

(Dollars in Millions)

Illustrative
Effect in 2005-06

Amount

Percent

Personal income tax

$2,320

5.9%

Sales and use tax

600

2.4

Corporation tax

300

3.5

Other revenues

30

0.6

Totals

$3,220

4.1%

Volatility of the Property Tax

Although the property tax in California is a local
revenue source, fluctuations in revenue growth
from this source nevertheless can have significant impacts on the
state's budget. This is because under the minimum funding guarantee for
K-14 education under Proposition 98, General Fund expenditures
are equal to the total guarantee minus the portion of the
guarantee that can be funded from local property taxes. Thus, increases (or reductions) in property tax revenues reduce (or increase), dollar
for dollar, General Fund financial obligations for schools.

As shown in the accompanying figure, local property taxes have exhibited less
volatility than the state's General Fund tax sourcesboth over the full 24-year period we have
examined and during its two individual subperiods. The average growth rate for this tax has been
7.5 percent, while the standard deviation has been 3.5 percent.

Factors Underlying Revenue Volatility

As discussed earlier and noted in Figure 7, California's revenue volatility
is related both to the state's general economic cycles and
the specific characteristics of its tax structure. Each
of these factors has played a major role in California's
revenue fluctuations in past years. California's
heavy dependence on the volatile PIT has been especially important.

·Consists of more volatile types of spending, such as sales
of building materials, autos, and business equipment.

¾Third largest tax, the CT, is very volatile

·Corporate profits fluctuate in such cyclical industries as
high technology, finance, and construction.

General Economic Fluctuations

Any revenue system that is highly responsive to economic
growth over the long term will necessarily be
affected by ups and downs in the economy over the course of a
business cycle. As indicated in Figure 8,
California's economy has historically been more cyclical
than the rest of the nation. This reflects several factors, including:

The presence of large numbers of high-paying
and cyclical technology-related industries, and

The growth-oriented and historically volatile housing sector.

A related factor has been the increased concentration of income in the state over
time among households at the top end of the income distribution. This is significant
because high-income households, who pay the
largest share of personal income taxes, tend to have
a larger share of their earnings related to such cyclical sources as bonuses, stock
options, capital gains, and business profits than
do households in the lower and middle portions of the income distribution.

Characteristics of the Tax System

As noted previously, California's revenue growth has fluctuated by considerably
more than statewide personal income growth during the past couple of decades. California's
tax system has several key features which have contributed to this above-average volatility.

In particular, California has become highly dependent on the PIT. Specifically, the
PIT's share of total revenues rose from 37 percent
in 1979-80 to a peak of 57 percent in
2000-01, before retreating some to 48 percent in 2003-04. The increased dependence on the PIT over time is significant because this tax has
two features that have contributed to
above-average volatility:

First, it has a highly progressive tax rate structure, with
marginal tax rates ranging from 1 percent to 9.3 percent. Many view this as
a positive attribute from a policy perspective, in that it links
tax burdens more strongly to the ability to pay. However,
this progressive structure also magnifies the effects on
revenues of the earnings volatility of higher income households.

Second, California, unlike the federal government and most
other states, does not provide preferential tax rates on
capital gains. Full taxation of capital gains has increased
California's dependence on this volatile revenue source relative to
most other states.

To a lesser extent, some other features of California's tax structure have also resulted
in increased volatility. As noted earlier, its SUT
is largely applied to the exchange of only
tangible personal property, and California has not
extended the SUT to many services. As a result, the tax is primarily influenced by the
more cyclical categories of spending, such as for
automobiles, residential and nonresidential
construction, computers, and other "big ticket" items.

Outlook for Volatility

We believe it is possible that the extreme swings in stock market-related revenues
experienced over the past decade may turn out to
be an historical anomaly. Thus, we would not expect the extreme volatility of the past
decade to become the rule. However, many other factors that have contributed to volatility in
the pastnamely, increased reliance on the PIT
and increasing concentrations of income at the
high-end of the income distributionare more permanent and thus likely to continue to contribute to volatility in the future. Given this, we
believe that significant revenue volatility will continue to be a major characteristic of California's tax
system, absent major policy changes to the tax system`s structure.

What Can Be Done About Revenue Volatility?

Given that a certain amount of volatility is inherent in California's current tax system
(both due to the economy and the system's own characteristics), and that volatility has
adverse effects on the state's budgeting, a
natural question to ask is: What actions, if any,
should be taken to deal with volatility in the
future? Fundamentally, policymakers have two types of options to
use individually or in combination for dealing
with revenue volatility:

First, they can revise the revenue system itself
to make it less volatile.

Second, they can focus on budgeting strategies
for managing volatility.

As indicated below, both of these approaches would
involve significant policy trade-offs that would need
to be considered.

Revising the Revenue System

Regarding the former approach, there are numerous changes that the Legislature
could make to the revenue system that would reduce its volatility. Figure 9 outlines some of the
key options that are available in this area,
provides estimates of how much their adoption
would have reduced volatility during the past 24
years, and identifies the key policy trade-offs
that would need to be considered. These options are discussed in more detail below.

Shift in tax burdens, either among income groups or among
taxpayers with different forms of income.

2.

Use income
averaging for capital gains

Moderate reduction.

Would not conform to federal law.

3.

Reduce
progressivity of the PIT rate structure

Potentially substantial reduction.

Shift in tax burdens among
income groups.

Reduction in revenue growth.

4.

Rebalance mix of
taxes away from PIT

Modest reduction.

Some shift in tax burdens among
income groups.

Some reduction in revenue growth.

5.

Modify the
corporation tax

Probably modest reduction.

Shift in tax burdens among
corporations.

Would reduce conformity with other states.

aFor purposes of this figure, "substantial" implies more
than 20 percent, "moderate" implies between 10 percent
and 20 percent, and "modest" implies less than 10 percent.

Reduce PIT Rates on Capital Gains

Probably the single most direct way to limit the state's exposure to the kind of
extreme revenue volatility experienced in the past decade would be to reduce its dependence
on the source of income that produced the greatest portion of this revenue
volatilitynamely, capital gains and perhaps stock options.
One obvious way to do this would be to reduce
their tax rates. Cutting the maximum state tax rate
on capital gains in half (from 9.3 percent to 4.65 percent) would have reduced total
revenue variability by about 12 percent during
the 1979-80 through 2003-04 historical period. Extending the preferential tax-rate treatment
to both capital gains and stock options would
have reduced volatility even moreby about
16 percent for the 1979-80 through 2003-04
period. The reduction in volatility would have been
an even greater 25 percent during the
post-1990 period. We would note, however, that
extending preferential rates to stock options
would result in a tax treatment in California that is
more generous than offered for this type of income
by either the federal government or other states.

Policy Issues and Trade-Offs. The
main policy trade-off is that this option would result
in a shift in tax burdens among taxpayers with different income levels and among
taxpayers who earn income from different sources.
A 50 percent reduction in the maximum rate on capital gains would reduce taxes paid by
$2.5 billion in 2005-06. Since over 90 percent of
capital gains are received by taxpayers in the top 5 percent of the income distribution, the
great majority of benefits from this change would similarly accrue to high-income taxpayers.
The revenue reductions could be offset through broad-based tax increases (such as a
one-half-cent increase in the SUT rate, or an
across-the-board 7 percent increase in each of the
current marginal PIT rates). However, both of
these options would shift the tax burden in
California away from high-income taxpayers to lower-
and middle-income taxpayers.

The state could avoid major changes in the tax burden between high-income and
other income groups under this option by replacing the lost revenues with higher maximum tax
rates on noncapital gains income, such as by imposing additional 10 percent and 11 percent
brackets on such income. However, such an increase would aggravate the disparity in tax rates
applied to different forms of income. It would
also impose an additional tax burden on those high-income taxpayers that derive most of
their earnings from wages, business profits, or
dividends. Finally, this option may be less feasible
as a result of voter approval of Proposition 63
in November 2004. This measure imposes a 1 percent PIT surcharge on taxable
incomes above $1 million.

Use Income Averaging for Capital Gains

An alternative change that would reduce the PIT's volatility without advantaging capital
gains and stock options through lower tax rates would be to adopt some type of
multiyear income averaging approach. This would
smooth out year-to-year fluctuations in reported
taxable income from capital gains and stock
options, thereby lessening volatility without having
to give significant preferential treatment to
these two sources of income. This approach would
be more neutral in terms of its impact on the behavioral decisions by taxpayers in
making investment choices.

Policy Issues and Trade-Offs. The
key trade-off related to this option is that it
would move California out of conformity with
federal tax law with regard to how capital gains
are calculated for tax purposes. It would thus impose a new record-keeping burden
on taxpayers and require them to use a different capital gains tax computation methodology
for state and federal purposes.

Reduce the Progressivity of the Basic PIT Rate Structure

This option would involve flattening the PIT marginal tax rate structure, by raising the
absolute and/or relative average rate on lower-
and moderate-income taxpayers and reducing those on high-income taxpayers. The
reduced progressivity would have two beneficial
effects on volatility. First, it would lessen the
state's relative dependence on capital gains,
business income, and other volatile income sources
that flow to high-income taxpayers and are thus currently subject to higher-than-average tax
rates (generally 9.3 percent versus the
7 percent average). Second, a flatter tax rate
structure would smooth out revenue growth over
business cycleslowering growth during
economic expansions (when increases in wages
currently push taxpayers into higher marginal tax
rate brackets) and raising growth in recessions (when falling incomes currently cause
taxpayers to slide back into lower tax brackets). At
the extreme, as noted in Figure 9 and illustrated
in Figure 10, if the state were to apply a flat tax
on all taxable personal income, the overall
volatility of California's revenue system would be
reduced by about one-third.

Policy Issues and Trade-Offs. A
reduction in the progressivity of the PIT rate
structure would have two key policy trade-offs. First,
it would result in significant shifts in tax
burdens from high-income to moderate-income and
low- income tax payers. The extent of this shift
would depend on the nature of the revised tax
system, but any change that reduces progressivity
will necessarily involve a shift in relative tax burdens.

Second, it would result in significantly less revenue growth over the long term. As
noted earlier in Figure 2, total General Fund
revenues have increased at about the same overall
pace as personal income over the past 24 years. Receipts from the PIT itself, however,
have grown modestly faster than the economy. This
is mainly due to its progressive tax rate
structure, where rising real incomes are subject to
higher tax rates over time.

As an example of the importance of progressivity to long-term revenue growth,
we estimate that if the state had had a flat PIT
rate structure in place since 1990-91, the
cumulative growth in revenues would have been over $7 billion less by 2003-04 than actually
occurred. (See lower half of Figure 10.)

Increase Reliance on Alternative Taxes

An alternative approach to directly changing treatment of capital gains or modifying the
PIT tax rate structure would be to retain the
current basic PIT structure but "rebalance" the
state's portfolio of taxes away from the PIT and
toward other taxes. Such a change could be made in
a revenue-neutral fashion through an across-the-board reduction in PIT rates and a
corresponding increase in other taxeseither through
tax rate increases or through a broadening of the alternative taxes' bases.

One of the attractive features of this option is that it could be used to both reduce
volatility and achieve other desirable objectives of
state tax policy. For example, the state could couple
a reduction in the PIT with a broadening of the SUT's base to include selected services.
This would achieve the dual objectives of reducing volatility (since spending on most services
tends to be relatively stable over a business cycle)
and equalizing tax treatment for different types
of purchases and businesses affected by them. At least modest reductions in revenue
volatility could result.

Policy Issues and Trade-Offs.Given
the highly progressive nature of California's PIT, any policy
thatreduces dependence on this tax is likely to result in
at least some shift in tax burdens among different income classes.
However, it would take a fairly drastic shift in
the reliance on different taxes to achieve a significant decline
in revenue volatility. Finally, any rebalancing
which reduces the state's dependence on California's
progressive PIT would likely result in less growth in
revenues over the long term.

Modify the CT

As noted earlier in Figure 2, the CT has consistently
been among the most volatile of California's taxes.
This is not surprising since even modest changes
in businesses' revenues and costs can translate into sometimes-dramatic changes in
bottom-line earnings.

Other provisions in the CT lawsuch as those relating to net operating loss
carry-forward deductions, research and development credits, and apportionment of
companies' worldwide income to the statealso
contribute to year-to-year fluctuations in revenues.

One option in this area would be to replace the existing tax on profits with a levy based
on gross receipts. Based on historical fluctuations
in business receipts versus profits during
business cycles, it would appear that a
receipts-based system could reduce volatility from the CT
by two-thirds or more. However, given the relatively small share of total revenues
attributable to the CT, the impact of this change on
overall state revenue volatility would be
relatively modestreducing total volatility by only
about 10 percent.

Policy Issues and Trade-Offs. There is
a policy rationale for basing taxes on gross receiptsnamely, that companies with a
significant presence in this state are directly or
indirectly using public servicessuch as
infrastructure and educationregardless of whether
or the extent to which they are profitable. However, such a system would result in
some companies paying more than presently, and
also would place California out of conformity with other states, most of which tax corporate profits.

The Bottom Line on Revising the Revenue System

As the above examples show, the state could reduce revenue volatility through
making a number of different changes to its basic
tax structure. Some of these changes, such as
those which broaden tax bases and reduce overall
tax rates, would result in other positive benefits
to the state's tax system. However, the options
that would have the greatest impact on lessening volatility would come with significant
policy trade-offs, such as changing the distribution
of the tax burden and lowering underlying revenue growth rates.

In any case, the dynamic and often volatile nature of California's economy implies that
even with substantial structural tax changes, the
state would still likely be left with significant
revenue volatility in the future. Any revenue system
that is responsive to economic growth over the
long term will inevitability be influenced by the
ups and downs of economic cycles in the shorter and medium term. Consequently, even if
California were to modify its tax structure, it would
be important to also consider budgetary tools as
an important option for dealing with revenue volatility in the future.

Budget-Management Options

In recent years, California has used a variety of budget management options to help
balance its budgets. Examples include spending
deferrals, accounting changes, shifts of program
responsibility from the General Fund to bond
funds, loans and transfers from special funds,
and borrowing from private markets.

While these tools can help the state avoid disruptive cuts to state programs in the
short term, they also have numerous negative consequences. For example, they can negatively
affect spending for special fund-supported
programs (such as transportation), and excess use
of budgetary borrowing can have adverse impacts on the state's credit rating. In subsequent
years, repayment of borrowed funds can also negatively affect the state's ability to fund
current priorities with current revenues.

The state has two other important options, however, that it can use during "good times"
to help it deal with the downsides of revenue volatility. These involve allocating some
revenue growth to one-time purposes and/or building
up substantial reserves.

Allocate Some Growth to One-Time Purposes

Under this option, a portion of revenue growth during good times could be
allocated for one-time purposes, such as capital
outlay financing, reduction of unfunded pension liabilities, payments toward other
deferred obligations, or providing one-time tax
relief. While this option would provide less of a cushion against volatility than a reserve, it
would at least help the state avoid ongoing commitments that it could not sustain during the
inevitable periods of revenue softness.

Policy Issues and Trade-Offs.
Followingperiods of chronic budget
shortfalls,there is often considerable pent-up demand for
spending on existing programs to cover enrollment, caseloads, and workload that were not
funded in prior years. The benefits of segregating
new funds for one-time purposes would need to be weighed against these pressures.

Budgetary Reserves

In our view, this option remains the most effective budgetary tool for dealing with
typical revenue fluctuations. Revenues set-aside into
a reserve during revenue accelerations and expansions can be used to preserve
program spending during revenue slow-downs and downturns, thereby "smoothing out"
program spending over time. Although California
has long included reserves as part of its annual budget plans, the size of these reserves
has been relatively modest compared to the annual fluctuations in revenues that have
actually occurred. As history has shown, these
reserves have fallen well short of what would have
been needed to effectively protect the state
against revenue fluctuations, particularly in recent years.

Proposition 58 Reserve
Targets. The approval of Proposition 58 by the voters in
the March 2004 elections makes funding future reserves a greater priority. Among other
things, this measure requires that a portion of
annual General Fund revenues be allocated to a Budget Stabilization Account (BSA) in each
year beginning in 2006-07. The set-asides for this purpose are 1 percent in 2006-07, 2 percent
in 2007-08, and 3 percent in 2008-09 and each year thereafter until the balance in the
account equals the greater of $8 billion or 5 percent
of annual General Fund revenues. These annual transfers to the BSA can be suspended
or reduced for a given fiscal year by an executive order issued by the Governor. In the case
of transfers from the BSA, these can occur through a majority vote of the Legislature.

Policy Issues and Trade-Offs. The
much larger reserve targets established by Proposition 58 are consistent with the levels that
the state would need to meaningfully insulate
itself from the effects of revenue volatility.
Although not providing coverage for all
contingencies, such as the extreme boom-bust revenue
cycle that began in the late 1990s, reserves along
the lines of those envisioned by
Proposition 58 would effectively deal with the more normal,
but still substantial, fluctuations that can
reasonably be expected to occur in future years. The
major policy trade-off for this option is that in order
to build-up a large reserve, it would be necessary to withhold funds from other General
Fund priorities. This trade-off is especially significant
in the current budget environment, where ongoing revenues are projected to fall short
of current-law expenditures during at least the
next several years.

Conclusion

Revenue volatility has long been present in California's tax system, but it became dramatic
in recent years. We believe that the extreme volatility associated with the recent stock
market boom and bust will likely prove to be an historical anomaly. However, several other
factorsin particular, California's dynamic economy and
the state's current heavy reliance on a highly progressive PITmean that revenue volatility
will remain a feature of California's current-law
tax system in the future. We have identified
several options involving changes to the state's
tax structure that could lessen future revenue volatility. Some of the options would
both reduce volatility and achieve other objectives
of state tax policy. However, certain other optionsincluding those that would have
the greatest impact on lessening
volatilitywould involve significant policy trade-offs that
would need to be considered. Among these
trade-offs would be redistributions of tax burdens
and possible effects on future revenue growth.

Even with tax reforms, it is likely that
California would continue to face significant volatility
in the future. Thus, we believe that any strategy
to deal with future volatility should include
reliance on budget management options. The most effective of these options is a large reserve, in
line with the targets established by Proposition 58.

Acknowledgments

This report was prepared by Brad
Williams and Jon
David Vasché. The Legislative Analyst's Office (LAO) is a nonpartisan office
which provides fiscal and policy information and advice to the
Legislature.

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